A call option is a financial instrument that gives its holder the right (but not the obligation) to purchase a given security at a pre-specified price, called the strike price or exercise price, from the option seller. This structure allows the option holder to profit if the price of the security exceeds the strike price at the time of expiry of the option. At the same time, the maximum possible loss to the holder is limited to the price paid for the option if the security is worth less than the exercise price, since the holder is not forced to buy the security at an above-market price.
Options usually have a limited lifespan (the term) and have two main styles of exercise, American and European. In an American-exercise call option, the security may be purchased for its strike price at any time during the term. In a European-exercise call option, in contrast, the security may only be purchased at the end of the term.
An indexed call option is one in which the role of “securities price” is played by an index, often an equity index such as the S&P 500 or the Nasdaq 100. Since delivering the basket of securities that compose the index is usually impractical, indexed call options are usually cash-settled. This means that if the index is greater than the strike price at time of exercise, the option seller pays the option holder the difference in price in cash: if the index is less than or equal to the strike, no payment is made.
Many investors currently purchase indexed call options directly to help achieve a desired balance of risk and return in their investment portfolios. Many consumers also benefit indirectly from investments in such options when they buy indexed deposit products such as equity-indexed annuities or indexed certificates of deposit (CD's). This is because indexed deposit products are usually constructed from a mixture of fixed-income instruments such as bonds or mortgages and indexed call options.
Investors and consumers obtain many benefits through the use of indexed call options, such as:
The ability to benefit from increases in the index while limiting the maximum loss to the price paid for the option;
Achievement of diversification by linking investment returns to an index aggregating the performance of multiple issuers, rather than just one security; and
Through indexed deposit products, achievement of a guaranteed return of principal together with investment returns linked to an index.
There are also some disadvantages associated with investment in indexed call options, including the following:
Inability to take advantage of changes in economic circumstances, because returns are tied to one index for the term of the option; and
Inability to “take shelter during a storm”—i.e. to link option returns to a safe alternative such as a credited interest rate during times of great perceived risk of index declines, and to resume index linkage as prospects improve.
Additionally, because the price of a call option increases less than linearly in the length of the term, the highest participation in increases in the index (per dollar of option premium) can usually be achieved by picking the longest option term available. This unfortunately makes it even harder for the option holder to take advantage of changes in economic circumstances.
The investor or consumer therefore must face the situation that shorter-term options provide greater flexibility but are more expensive, while longer-term options provide greater potential return but are less flexible. A difficult choice must be made.
Accordingly, there is a long-felt need for an indexed call option structure permitting the purchaser to achieve the benefits associated with longer terms, while providing the greater flexibility characteristic of shorter terms. There is correspondingly a long-felt need for a computer-based system for valuing such an indexed call option structure.